Maltese economy will grow by nearly 4% on average over 2017-2020 in real terms, allowing for a further reduction in general government debt to GDP.

We project that the Maltese economy will grow by nearly 4% on average over
2017-2020 in real terms, allowing for a further reduction in general
government debt to GDP.

We are therefore revising the outlook on our long-term sovereign credit
ratings on Malta to positive from stable, and affirming the 'A-/A-2' long-
and short-term ratings.

The positive outlook reflects that we could raise the ratings on Malta
over the next 24 months if economic growth remains in line with our
expectations and is not derailed by factors such as external risks, and if
budgetary consolidation and the reform of state-owned enterprises
continues.

OUTLOOK

The outlook revision reflects our expectation that Malta's economy will
continue its strong cyclical expansion, growing by nearly 4% on average over
2017-2020 in real terms, enabling a further consolidation of public finances.

We could raise the ratings if:

Economic growth is in line with our expectations and is not derailed by
factors such as external risks (for example, the effects of Brexit or
increasing international regulation of key sectors such as financial
services and e-gaming); and

Budgetary consolidation proceeds and contingent liabilities are reduced
through the ongoing reform of state-owned enterprises.

We could lower the ratings if we see substantial slippage in Malta's fiscal
performance, increasing risks to the performance of key service sectors, or
overheating in the financial sector driven by the domestic savings glut.

RATIONALE

Our ratings on Malta are supported by its strong growth performance coupled
with consistent current account surpluses, as well as by narrowing general
government deficits and improved fiscal management. The ratings are
constrained by Malta's relative vulnerability to changing international
financial and political conditions; its small, open economy; the fact that the
resilience of its new economic sectors remains untested by external shocks;
and its limited monetary flexibility. The ratings are also constrained by the
frequent revisions in some sections of Malta's macroeconomic data, and our
limited visibility on external risks given the presence of large flows into
and out of Malta, particularly in the financial sector, which also inflate the
country's external liquidity metrics.

Institutional and Economic Profile: The proliferation of new sectors is
fueling Malta's strong economic growth

We project the economy will grow by an average of 4% over 2017-2020,
decelerating as new sectors start to mature.

Risks to our growth expectations emanate from the structure of Malta's
small, open economy, and from evolving global tax regulation.

We anticipate gradual reform implementation through 2020.

Malta continues to enjoy one of the strongest macroeconomic expansions in the
eurozone. Real GDP growth averaged 4.7% in 2010-2016 and we expect it to
average nearly 4% over 2017-2020. The structure of Malta's economy has changed
significantly over the past half-decade, during which the growth of
traditional manufacturing and financial service exports has moderated.
Instead, growth has been dominated by the proliferation of new services
exports such as logistics and e-gaming. In 2014-2016, significant investments
in energy and logistics also made important contributions to growth.

Going forward, we expect the pace of growth to decelerate somewhat as the new
sectors that have so far been in expansionary mode start to mature.
Furthermore, several projects--particularly in the energy sector--that have
contributed positively to growth have reached completion. Nevertheless, we
anticipate that Malta's growth will continue to exceed that of peers at
similar income levels and stages of development.

That said, there are several risks to our growth projections, not least those
stemming from Malta's small, open economy, which is exposed to various
potential external shocks, such as Brexit. Tourists from the U.K. generate 30%
of tourism receipts; in 2017, receipts from British tourists declined owing to
the depreciation of sterling. However, tourists from other European countries
have more than compensated for this shortfall. The Ministry of Finance
estimates that while tourism contributes about 5% to GDP directly, the figure
rises to nearly 20% when indirect and induced effects are considered.
U.K.-exposed segments of Malta's very large financial sector could also
experience disruption. Nonetheless, we believe that Malta is generally
well-placed to withstand Brexit shocks, as it has a diversified export base
and a flexible economy.

Another risk is evolving global tax regulation. Malta's tax regime, an
important factor for investors in certain sectors, will be tested by several
measures that have been adopted or proposed at European and global levels. For
example, the Anti-Tax Avoidance Directive (ATAD) requires Malta to reform some
aspects of its corporate taxation by 2019. Other proposals, such as the Common
Consolidated Corporate Tax Base (CCCTB) may put further pressure on Malta,
especially as the political balance within the EU may change after the U.K.'s
departure. Any future regulatory pressures on the e-gaming sector could also
have negative implications for Malta's economy, given that this industry has
contributed increasingly to the country's growth in recent years.

Snap elections were held in June 2017, a fallout from the Panama Papers
scandal. The incumbent Labour Party, led by Prime Minister Joseph Muscat,
secured a four-seat majority. In recent years, amid a high-growth environment,
the government has consolidated public finances, reduced the general
government debt-to-GDP ratio, and undertaken several structural reforms,
notably to increase the participation rate in the labor market and to reduce
the country's energy bill. We anticipate that macroeconomic policymaking will
remain geared toward further fiscal consolidation. Efforts to reform
state-owned enterprises further, reduce skill mismatches, and improve the
long-term sustainability of public finances in the context of an aging
population will be implemented gradually.

Flexibility and Performance Profile: Malta's high gross external debt does not
fund its domestic growth

We anticipate further fiscal consolidation over the forecast horizon, with
general government debt-to-GDP on a declining trajectory.

We project that Malta's current account will remain in surplus over
2017-2020, driven by robust service exports.

The corporate tax regime is one of the factors that encourages companies to
create subsidiaries in Malta and book some of their activities through it.
Such activity contributes to an inflated gross international investment
position of about 20x GDP--even though on a net basis, it is an external
creditor--and to considerable gross flows on the financial account of the
balance of payments, which considerably inflate Malta's external liquidity
metrics. Those flows are mostly pass-through and do not fund the domestic
economy, but the reduction of their volume could reduce service exports by
noticeable amounts.

The current account has been in surplus since 2012, though its magnitude has
been revised several times. Malta's external data is subject to frequent
revisions, which constrains our analysis. Most of the external debt inflows
result in matching outflows and do not generally fund domestic growth.

Malta's banking sector is split into three well-identified subsectors: core
domestic banks; noncore domestic banks; and international banks. The two
biggest core domestic banks are overwhelmingly focused on activities in Malta,
although some smaller core banks undertake some international activities, such
as participating in syndicated loans. The international banks, as of 2016, had
an estimated balance sheet of about 220% of GDP (out of 465% of the total
banking sector). They operate a variety of business models, including
onlending their parents' funds abroad and attracting nonresident deposits to
fund parents. Although this subsector has been shrinking for several years, it
still has a considerable effect on external accounts. That said, it generates
limited employment and does not have close links with the domestic economy.
Dislocations in the funding for international banks could still affect the
island's reputation as a financial center.

The bulk of the government's contingent liabilities comes from guarantees to
government-related entities. Overall fiscal management has improved, but
guarantees still constitute over 12% of GDP. Malta has made considerable
progress in fiscal consolidation; we expect net debt to fall to below 40% of
GDP by 2020, though this projection is highly sensitive to the evolution of
nominal GDP. The government's budgetary position moved into a surplus of 1% of
GDP in 2016. We expect small surpluses over the forecast horizon arising from
additional public savings from further spending reviews and reforms to improve
tax administration.

Credit growth has been weak as corporates continue to deleverage. New loan
growth has been driven entirely by households, particularly via demand for
mortgages. The government intends to capitalize a development bank with €200
million (about 2% of GDP) to provide credit to small and midsize enterprises
and for infrastructure projects where funding is not easily forthcoming. The
details regarding the timing and financing of the capitalization have not yet
been made available. We anticipate that, regardless of the means of financing
the initial injection, the impact will increase net general government debt.
We have therefore added €30 million (0.3% of GDP) to our calculation of
government debt. We understand this is the likely size of the initial
injection; we will increase the amount we add to government debt as and when
further injections are made to raise the bank's capital.

Household savings remain high (net financial assets of households are about
180% of GDP), with the local financial market offering limited options to
place them. Therefore, most of them are deposited with banks, contributing to
loan-to-deposit ratios averaging less than 60% and an overall domestic savings
glut. There is some evidence that households are increasing their appetite for
higher-yielding investments, such as real estate and local corporate bonds.
Although the growth in real estate prices is mainly driven by structural
factors such as population growth, the domestic recycling of savings could
eventually contribute to the overheating of the property market and trigger
financial stability concerns.

Membership of the eurozone anchors Malta's monetary policy and provides its
banks with access to funding at low nominal interest rates. Nevertheless, we
consider that membership in a monetary union increases the onus on member
governments to support competitiveness through fluid labour, product, and
services markets, and to build up fiscal buffers against future shocks.
Malta's inflation patterns diverge from eurozone averages, although the
variation has reduced because energy markets have integrated; nonetheless, the
European Central Bank is less likely to consider the economies of smaller
members when setting monetary policy, and this remains a constraint on Malta's
monetary flexibility. Moreover, the integration of Malta's financial system
into the eurozone appears to be insufficient to achieve efficient placement of
surplus domestic savings, even though this issue is partly caused by the
traditional home bias of domestic savers.